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November 26, 2013

Fixing the CFP Board’s ‘Three Buckets’ Rule

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In the first part of this two-part series, I discussed the problems inherent in the CFP Board’s “three buckets” approach to advisor compensation. That approach leads to the situation where fee-only firms are apparently not permitted to call themselves "fee only" because an "unrelated" party is associated with commissions.

So what's the resolution to fix the CFP Board's problematic rule? The key is to recognize that the fundamental purpose of compensation disclosure is to disclose how advisors are compensated by their clients, which means the starting point should always be what clients actually pay to various parties.

Accordingly, advisors should really only ever have to disclose compensation associated with buckets No. 1 and No. 2, which cover what the advisor is paid, and what is paid to the advisor's related parties. In fact, arguably the original purpose of bucket No. 3—how the advisor himself generates income from his employment and ownership interests—was simply to recognize that in order to determine whether an outside party is related or not, it must be determined if the advisor is receiving any direct or indirect compensation from that party.

For example, if an advisor refers a client out to TermInsurance.com for insurance needs, the client will technically pay a commission (as it's part of the cost of term insurance), but the commission will be paid directly to the website, and none of that compensation will flow back to the advisor. In that scenario, since bucket No. 2 will be filled with respect to the transaction, but bucket No. 3 will not, the party is not actually a related party and therefore the advisor would not be required to disclose commission-and-fee compensation (which makes sense, as the advisor isn't actually receiving any commissions, directly or indirectly, and is referring the business out!).

Alternatively, if the advisor referred the client to do term insurance with an insurance agency the advisor owns—which means the advisor would receive indirect compensation for the commissions paid in the form of dividend distributions from the insurance agency—then it would be necessary to disclose commissions, because the advisor is actually receiving a benefit from the commissions that the client paid. (Notably, this appears to be the exact circumstances at hand in the Camarda case, where the advisors claimed to be fee-only but routed clients to do commission business with an entity owned by that advisor.)

What this means is that the real purpose of bucket No. 3 in the three-bucket rule is to determine whether the CFP certificant is receiving a direct or indirect benefit of a commission (or fee) paid to an outside party. In other words, in a world where the term "related party" is actually not defined by the CFP Board, the third bucket essentially creates that definition: a related party is one that provides a non-trivial direct or indirect economic benefit is paid to the advisor, whether through an employment relationship or an ownership relationship.

Nonetheless, the existence of a third bucket is not proof that the advisor receives commissions, because it fails to establish whether any client ever actually pays any commissions to that party in the first place! It simply creates the potential that an advisor could receive such compensation if there is an intention or actual situation where clients can/will do business with that commission-based entity to begin with.

Three Buckets Really Should Be TwoAs a result, the CFP Board needs to recognize that its three-bucket strategy is really a two-bucket strategy: either the client pays the advisor, or the client pays an outside party that is related. The only purpose of the third bucket (which might be better renamed "Bucket 2b") is to determine if an outside party that received a commission is a related party or not.

To view outside relationships in the absence of what the client actually pays simply leads to nonsensical outcomes; scenarios where no client actually pays a commission to anyone in any way at any time, yet the advisor must disclose that he/she is receiving a commission that doesn't exist in the first place!

The CFP Board can fix this definition at any time, because the three-bucket strategy is not part of the official Practice Standards, and is merely an internal self-created administrative framework used to interpret (or perhaps now misinterpret!) those rules. Such a fix would help greatly to resolve a number of problematic situations the CFP Board is now facing. Those situations include advisors who maintain an insurance license (e.g., for advisory purposes) that means they could earn a commission but have no intention to do so, to advisors whose clients pay only and entirely fees but happen to have an ownership interest in an outside "unrelated" commissionable entity that no clients do business with (from a family insurance business to owning stock in a bank or broker-dealer to having a portion of a large firm owned by a financial services holding company), to advisors who happen to work for a broker-dealer or bank but no clients ever actually pay a commission to anyone.

In fact, given the CFP Board's rules, there are also thousands of "commission-only" advisors who are also in violation of the compensation disclosure rules. As I pointed out months ago, it's virtually impossible to find a financial services firm that isn't at least capableof charging a fee. That being the case, any advisor working for such a firm—which would be alladvisors!—cannot be commission-only and in fact should be required to disclose that they are commission-and-fee as well!In other words, the CFP Board's problematic rule not only casts a large number of fee-only advisors as "commission and fee" by ignoring what clients actually pay; it also leaves virtually every "commission-only" advisor equally in violation of the rules as well for the same reason!

Again, the common theme to all of these problem situations is that the CFP Board is basing compensation on what "could" happen and the nature of the firms advisors work for, are affiliated with, or simply own as a part of their portfolio, while failing to recognize and remember that the whole purpose of compensation disclosure is to disclose based on what clients actually pay.

If no clients ever pay commissions to anyone in the first place, a mere ownership or employment relationship should not "taint" the characterization of the advisor as being "fee only" (any more than working at a firm that could earn a fee should taint an advisor's disclosure of "commission-only" if the truth is that they really are solely compensated from client by commissions.).

Instead, a requirement to disclose "commission and fee" should only pertain to situations where the clients actually pay a commission and a fee in the first place, and it can be shown that the commission and fee were each paid to the advisor and/or a related party.

At that point, we'll finally have a logical compensation disclosure rule: where advisors must disclose how they're compensated based on what clients actually pay, the determination of a related party is based on whether the advisor receives a direct or indirect non-trivial economic benefit, and advisors are not required to disclose commissions (or fees) that don't actually exist in the first place.

After all, just think of it from the client's perspective. Are we really helping to bring clarity to consumers, which is the whole point of compensation disclosure in the first place, by requiring advisors to disclose types of compensation that don't actually exist and their clients won't pay in the first place. Wouldn't it be a clearer and stronger consumer protection to require advisors to disclose how they're actually being compensated by their clients? Why is that so hard for the CFP Board to implement?